Fixed Income

Here at FFTW, we came into 2015 believing that a host of structural factors would serve to keep the global stance of monetary policy stimulative and long-term interest rates low, even if the Federal Reserve (Fed) were to begin gradually raising interest rates. On the structural front, we have been struck by just how little deleveraging has occurred since the financial crisis across public and private sector balance sheets in both the developed and emerging worlds. In addition, while Japan and much of Europe face significant demographic challenges as a result of aging populations, the demographic picture in the United States and China is not that much brighter. And in the US and elsewhere, productivity remains quite low, perhaps as a result of restrained capital investment since the beginning of the financial crisis. Together, these forces imply lower global growth potential compared to a decade ago, constrained fiscal policy options, and increased vulnerability to future economic shocks.

If structural factors point to a low-growth, low-inflation environment, cyclical factors paint a more mixed picture. Fiscal policy has clearly passed its peak point of contraction in both the United States and the Eurozone, and oil price declines should bolster global consumer spending. However, the disinflationary effects of low oil prices will take a while longer to work through the global economy. In addition, even as potential growth in China declines, realized growth has declined more rapidly, and the resulting output gap has contributed to global disinflation. In short, for the foreseeable future we remain in a global environment of moderate growth (both realized and potential), with little upward pressure on inflation.

Against this backdrop, what do we make of the 40 basis point rise in nominal Treasury yields between 2 February 2015 and 20 February 2015? Charts 1 and 2 (see below) show 10-year nominal Treasury yields, as well as their risk-neutral and term premium components, for the prior tightening cycle (2004 through 2008) and for the current period (2011 to 2015). For the current period, the decomposition reveals that almost the entire recent rise in the 10-year yield is due to a re-pricing of the estimated term premium from deeply negative levels, while the risk-neutral yield (the expected path of short-term rates over the next ten years) remained stable. The term premium represents the compensation that investors demand for holding a long-duration asset in an uncertain world, and its recent rise likely stems from three factors. First, the inflation risk premium has likely increased a bit as oil prices have bounced off of recent lows. Second, an exceptionally strong January employment report has led to somewhat higher policy uncertainty. And finally, risk sentiment has improved in the wake of the recent agreement between the Greek government and its international creditors. The resulting reversal of flight-to-safety flows translates to a higher term premium.

It is difficult to imagine that the recent rise in 10-year yields will continue to any meaningful extent in the near term. The structural factors mentioned above imply a low probability of an upward shock to growth or inflation expectations, which should keep the risk-neutral component of the 10-year yield on a very gradual upward trajectory over the course of the year. Meanwhile, the term premium may struggle to increase much above zero. Absent a communications error by the Federal Reserve, approaching monetary policy tightening is very unlikely to lead to a sharp increase in the term premium for the simple reason that policymakers will continue to rely on forward policy guidance that limits policy uncertainty and suppresses rate volatility. Specifically, recent policy statements have communicated that, “even after employment and inflation are near mandate-consistent levels, economic conditions may…warrant keeping the target federal funds rate below levels the Federal Open Market Committee (FOMC) views as normal in the longer run.” While not a firm commitment, this language amounts to a soft pledge that the policy rate will remain well below the long-run equilibrium rate for at least the next two years.

The prior tightening cycle provides striking supporting evidence of the effect that forward guidance can have on the term premium. As you can see in chart 1 (below), the term premium commenced a downward march as the Federal Reserve strengthened its forward guidance in 2004. In January of that year, the policy statement indicated that the FOMC would be patient in removing policy accommodation, and in May, just prior to raising rates, the statement began indicating that tightening would occur at “a pace that is likely to be measured.” The FOMC would retain this volatility-compressing language in its next eleven policy statements as it embarked on the most telegraphed tightening cycle in its history.

Other factors served to suppress the term premium in the prior tightening cycle, especially the global savings glut that saw current account surpluses recycled into the US Treasury market. While this factor may not be as prevalent a force now as it was in the 2004-2007 period, a new global factor will contribute to a low Treasury term premium, namely, quantitative easing abroad. So long as sovereign rates remain extraordinarily low elsewhere, any backup in US rates will present a buying opportunity for international investors. The Federal Reserve may begin tightening this year, but global term premium suppression is a difficult force to fight.

Chart 1: Yield of the 10-year US Treasury bond (blue line) for the period from 2004 to 2008, with a decomposition of this yield into the term premium (grey line) and risk-neutral (green line) components. This chart clearly illustrates how the term premium commenced a downward march as the Federal Reserve strengthened its forward guidance in 2004. In May 2004, just prior to raising rates, the FOMC’s statement began by indicating that tightening would occur at “a pace that is likely to be measured.” The FOMC would retain this volatility-compressing language in its next eleven policy statements as it embarked on the most telegraphed tightening cycle in its history.

Chart 2: Yield of the 10-year US Treasury bond for the period from 2011 to 2015 (blue line), with a decomposition of this yield into the term premium (grey line) and risk-neutral (green line) components. The decomposition reveals that almost the entire recent rise (i.e. from a yield of around 2.48% on 02/02/15 to a yield of around 2.83% on 20/2/15) in the yield of the US 10-year Treasury bond is due to a re-pricing of the estimated term premium from deeply negative levels,

Source of data for graphs: Federal Reserve Bank of New York as of 20 February 2015.